This blog covers financial, political and other topics the author gets the urge to write about. It does not provide personal financial, legal or other advice. Consider consulting a personal professional adviser before making any decisions. Copyright (c) 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019 by Leonard W. Wang. All rights reserved.

Tuesday, September 29, 2009

Let's say your retirement savings have been pummeled in the last couple of years. You've lost faith in the stock market, and haven't jumped back in notwithstanding this year's rally. You're in good company, as numerous long term investors (such as individuals saving for retirement) haven't taken the bait on the current bull market, or bear market rally, or whatever it will turn out to be with the benefit of hindsight. They prefer to avoid loss, and given recent history, that's not a bad strategy.

But we still have the question of what to do financially about the future. Bear in mind the simple power of compounding. Compounding comes about when you save and reinvest the income from your savings. It is particularly effective when you add to your savings regularly, like every pay day. Look at the following example.

Assume you're 15 years away from retirement and you can barely bring yourself to look at your 401(k) account statements. In the past you weren't so committed to building the account and you now have a recession-diminished balance of $100,000. You understand that, more than ever, you're responsible for making your retirement years golden. You resolve that you're not going to have dog food as part of your diet in old age, and seriously rearrange your financial priorities so that you can contribute the maximum amount permitted by IRS regulations to your 401(k), currently $16,500 a year. You've had it with the stock market and decide to stick to high quality bonds. We'll assume you can earn an average return of 4% per year on your all-bond portfolio. At the end of the remaining 15 years of your working life, your 401(k) account will have a balance of approximately $510,000. If we assume that inflation runs at its historic average of 3% per year, your inflation adjusted balance will be about $323,000.

In other words, if you buckle down now and max out your 401(k) for the rest of your career, you can give your retirement account balance a very large boost, even with modest returns and adjustment for inflation. This is what compounding does. By saving more each pay day and reinvesting your returns, you can leverage up your retirement savings dramatically.

Most of the financial advice you see on the Internet and in other news media focus on an endless array of investments, strategies, choices and decisions. But much and perhaps most of the mileage you can get from your capital comes from compounding. Your choice of investment strategies and the allocation of your portfolio may give you greater or lesser potential profits, at the risk of greater or lesser volatility. But the discipline of saving on a compounded basis is the foundation on which everything else rests. If you love compounding, compounding will love you.

Sunday, September 27, 2009

One reason why the 1990s were a period of great prosperity was the peace dividend, the reduction in government spending resulting from the end of the Cold War. When the Soviet Union collapsed in 1991, the U.S. was able to greatly reduce military spending. Freeing up billions of dollars for private sector investment and spending allowed the civilian economy to prosper.

A major reason why the U.S. now burdens under enormous deficits is the ill-conceived war in Iraq, which caused the federal budget's surplus at the end of the Clinton Presidency to go negative to the tune of hundreds of billions of dollars during the George W. Bush Presidency. The war in Iraq is winding down. But military spending hasn't abated significantly because of the war in Afghanistan.

The President is wrestling with the problem of increasing troop levels in Afghanistan. While much has been leaked to the press about this supposedly secret issue, not enough has been leaked to justify stepping up the war. There has been no articulation of an achievable goal. Lasting military victory is essentially impossible. Whatever Allied troops may accomplish at any location where they are concentrated, the Taliban can always retreat into Pakistan (our ally, as it were), where they will receive sanctuary and succor. Then, when rested, resupplied and reinforced, they can probe the endlessly snarled and remote Pakistan-Afghanistan border until they find a weak spot and return to fight another day. A similar strategy of fighting and then retreating into safehavens was used by Afghan mujahideen guerillas in the 1980s to fight and eventually defeat a Soviet force much larger and nastier than the current Allied force. How could an even enlarged Allied force, with its current rules of engagement, inflict lasting defeat on the Taliban?

Politically, the Bush II administration's guy in Kabul, Hamid Karzai, is rapidly losing any legitimacy as a result of rampant voting fraud in the recent Afghan elections. If even half of the allegations about Karzai's camp are accurate, one would have to conclude that, in a head-to-head election, Karzai could have beaten Richard Daley the elder by a landslide. Nation building in Iraq had a degree of success only because the Shiite majority was able to participate in largely fair elections. We now have a morass in Afghanistan that brings to mind the Diem brothers, whose corrupt rule of Vietnam was brought to an end by their U.S.-approved assassination in 1963.

The Taliban are primarily Pashtun, the largest ethnic group in eastern Afghanistan and northwestern Pakistan. In essence, the U.S. and its allies are very close to fighting a 19th century colonial war, trying to suppress the local populace and install a friendly government that would be perceived as a puppet regime. The experience of the erstwhile European colonial powers teaches that this isn't a winning strategy.

The U.S. has no vital national interest in conquering the Pashtun or the Taliban. We should work toward a negotiated resolution with Taliban leaders in which they are made to understand that harboring Al Queda will bring a robust U.S. military response, and ejecting Al Queda from its Pakistani sanctuaries will bring a meaningful flow of dollars. That wouldn't be pretty, but it's how we attained--rather, bought--peace in Iraq. A number of Sunni and Shiite leaders in Iraq were the beneficiaries of U.S. payments. They called off the young men from their tribes and assisted Allied intelligence in identifying Al Queda personnel. Al Queda was suppressed to a large degree, and the ensuing drop in violence gave the U.S. political cover to withdraw its troops from combat operations.

Going back in time, we did the same thing in the 1970s. For the last 30 or so years, Egypt has been the recipient of billions of dollars of U.S. aid. The sole--repeat, sole--reason for this aid was Egypt's willingness to sign a peace treaty with Israel. We're paying the Egyptians to refrain from burning off ammo in Israel's direction. Why not pay the Taliban to stop shooting at American personnel?

America needs a peace dividend. The costs of economic stimulus, health care reform, Social Security and Medicare loom more than ever before. There are many good reasons aside from financial cost to wind down the Afghan war. But in a time of economic distress and uncertain prospects for the future, ending an increasingly unpopular war would not only be the right thing to do, it would probably be a fiscally smart thing to do.

Presidents haven't suffered politically for taking America out of military morasses. Ronald Reagan's standing was hardly damaged at all by his 1983 decision to withdraw U.S. troops from hopeless entanglement in Lebanon. Bill Clinton's legacy suffered no lasting tarnish from his decision to pull U.S. forces out of the chaos in Somalia. Richard Nixon's tarnished legacy was probably improved by his decision to sign a peace treaty with North Vietnam, even though doing so made an eventual North Vietnamese victory in the South predictable. Dwight Eisenhower was elected on his promise to negotiate an end to the stalemated fighting in Korea. Barack Obama doesn't yet bear the blame for America's mistakes in Afghanistan and could look presidential by folding a bad hand.

Thursday, September 24, 2009

The Federal Reserve just told us that inflation isn't a worry. But let's remember that this is the agency that solemnly told us the mortgage crisis was manageable, even though one of its own members warned of problems. The Fed also didn't see the credit crunch coming, even though it's the top bank regulator. Then the Fed had to wing it with massive amounts of printed money in order to prevent the financial system from collapsing. Perhaps, in spite of official reassurances, one might wonder if those truckloads of printed money will have an unexpected inflationary effect. If you want a little inflation protection just in case, here are a few suggestions.

U.S. Treasury TIPS. TIPS are inflation adjusted U.S. Treasury bonds. They pay interest and also provide an inflation adjustment. You're taxed on the inflation adjustment as well as the interest, so your true inflation protection is reduced by taxes. And you have to pay taxes on the inflation adjustment on an ongoing basis even though you don't actually receive the amount of the adjustment until the bond matures (which could be years in the future). So you may have a cash flow issue. Nevertheless, there's no credit risk and that means something in these days when credit is still crunched.

U.S. I Savings Bonds. You can buy I Savings Bonds, which are inflation adjust savings bonds. Unlike TIPS, you don't have to pay any income tax on I Savings Bonds until the bond is redeemed or matures. Unfortunately, you can't buy more than $5,000 of I Savings Bonds a year. If you want to invest more in a U.S. Treasury obligation, you'd have to buy TIPS.

Inflation Adjusted Annuity. Some insurance companies offer annuities that provide for increased payments to compensate for insurance. These annuities aren't cheap--they often start paying at levels significantly lower than the amount of a fixed annuity you could buy for the same amount of capital. But there's a certain level of comfort in knowing that you'll get an increased monthly payment if inflation flares. Remember that annuities are subject to the creditworthiness of the insurance company. Also read the fine print for any limitations on the extent of the inflation protection. For more, see http://blogger.uncleleosden.com/2007/06/annuities.html.

Stocks? Over long periods of time, stocks keep pace with inflation and even sometimes exceed inflation. But we're talking 25, 30 or more years. During the inflationary 1970s, stock investors lost their shirts to the depreciating dollar. If you bought stocks in the early 1970s, you didn't recover your losses on an inflation adjusted basis until the early 1990s (not a typo, not kidding). If you're 25 and saving for a retirement 40 years from now, stocks are a good idea for much of your portfolio. But if you're 70, don't view stocks as inflation protection. It might be worthwhile to have a modest portion of your money invested in stocks, just to catch any market upswings. But for inflation protection over the next 10 or 15 years, think about TIPS and I Savings Bonds, or maybe an inflation adjusted annuity from a very highly rated insurance company.

None of the above offer complete protection against inflation. But they're worth keeping in mind if you're not entirely sure you can rely on official assurances that all is quiet on the inflation front. Think about diversifying your inflation protection. Put some money in I Savings Bonds and TIPS, and possibly in an annuity or stocks. And keep working as long as possible.

Tuesday, September 22, 2009

At its ongoing September 2009 meeting, the Fed is considering how and when to withdraw the myriad liquidity accommodations it has provided to stabilize the financial system. Conventional wisdom holds that the Fed should proceed very gradually, and only if the financial sector doesn't whimper, lest the fragile economic recovery be jeopardized. Great fear is expressed of precipitously taking away the punch bowl just as the party is getting going. Grave allusions to the Fed's stinginess in the 1930s are made with knowingly raised eyebrows. Official winks and nods signaling continued easy money are aimed at the center of the financial district.

But we seem to have a fresh set of asset bubbles. The stock market has had an extraordinary rebound. Oil prices have bounced back from their winter lows without much increase in underlying demand. Let's remember that in money matters, if it looks too good to be true, it probably isn't true. The current financial recovery hasn't been matched by a corresponding recovery in the real economy. There, sightings of green shoots are all that can be reported amidst growing unemployment. When asset prices rise without a lot of good reason, keep your hands on your wallet and your cash in safe places.

After the last ten years of Fed easy money instigated asset bubbles in tech stocks, real estate, mortgage credit, and petroleum, one can't avoid suspecting that today's bubbliness is the result of the Fed's liquidity accommodations. To make things worse, the big banks are smack in the middle of the current asset bubbles and would probably be hammered if things fell apart. The Fed is making noise about winding down its accommodations well before anything happens, probably in the hope that plenty of notice will give the big banks time to prepare for the end of the party. But will this work? There was plenty of notice of Bear Stearns' problems, yet a federal bailout was necessary to prevent panic when the Bear went down. There was even more notice of Lehman's problems, but who was prepared for its bankruptcy? AIG's problems should have been apparent to the credit default swap buying crowd, since those swaps were for mortgage-backed investments and AIG's principal counterparties were major financial institutions that were well-aware of the mortgage mess. Yet AIG got a whopper of a bailout because way too many big banks were way too exposed.

Giving notice won't do much to curb Wall Street's excesses. Why? Because Wall Street is the home of the short term. If there's a short term buck to be made today, then damn the torpedoes and full speed ahead. This quarter's earnings and this year's bonus depend on short term profits. The Fed's easy money policies have made short term trading and speculation highly profitable and profitability is a competitive issue. A firm's ability to hire and retain the best personnel depend on high profits and a booming stock price. Just about every major bank has serious Goldman envy, and they wouldn't be inclined to back away from a short term speculative trade if they thought they'd have to report lower profitability than GS. As long as the short term profit song is playing, everyone is going to keep doing the short term dance.

So when the Fed, sooner or later--well, probably later--begins to withdraw its accommodations, the current ongoing bubbles may well deflate, and the Street won't be prepared. Cries for federal intervention will recur. But what could the Fed do at that point? Its zero interest policy would have been a cause of the problem, not the solution.

Yet the Fed can't keep all this accommodation out there indefinitely. There is, ultimately, a risk of inflation. The Fed is at a fork in the road and may be damned whichever way it goes. Unless fiscal policy or something gets the real economy going, things could be ugly. Let's just hope that when this dervish stops whirling, we don't all collapse into a feverish coma.

Friday, September 18, 2009

The nationalization of the banking system continues. Even as healthier banks repay their TARP funds, the Fed is now proposing comprehensive regulation of banker compensation. It's not talking only about executive pay. It means to cover compensation arrangements down to mid-levels and perhaps even lower. The idea is to prevent banks from creating and accumulating the outsized and uncontrolled risks that led to the current economic mess. All the annoyed bank vice presidents out there have AIG-Financial Products to thank for the comprehensive scale of the proposed regulation. AIG-FP was one of many subsidiaries of AIG, the grand bailee of the financial services industry. FP, all by its little old lonesome, sold so many credit default swaps, and thusly saddled AIG with so much risk, that the U.S. financial system almost blew up when FP's counterparties began to demand collateral that it couldn't provide. As we all know, the American taxpayers, generous to a fault and holding bankers dear to their hearts, rushed forward with more than $100 billion to save AIG from bankruptcy.

Because the federal government, through its now engraved in stone too-big-to-fail doctrine or through federal deposit insurance, is on the hook for virtually all liabilities of all banks, there is a logic to comprehensive regulation of bank risk taking. After all, the banks' own signal failure to manage risk created the mess we're in, and there's not a lot of evidence that they've changed their ways. Indeed, bank risk levels now seem higher than before the economic crisis. (See http://blogger.uncleleosden.com/2009/09/risks-of-business-as-usual-in-banking.html.)

The Fed wants to ensure that banks have sensible pay policies. Can't argue with that. But government agencies don't regulate simply by prescribing policies. They have to follow up and verify that the banks are following their policies (that's called enforcement of the rules). Federal examiners would have to routinely review compensation of, say, bank vice presidents (those would be the folks that open checking and savings accounts, and make mortgage loans). We'd practically have the government managing the banks--all of them. Admittedly, many are the bankers that deserve a trip to the wood shed from which they would return with tenderized butts. However, having federal officials countersign bank employee paychecks implicates the government really deeply in the doings of the banks. The next time there is a banking crisis--and you can bet your last penny that there will be more banking crises--the federal government will bear even more blame than it has been smacked with this time.

Back in the bad old days of 3-6-3 savings and loan mortgage lending, cars had big fins and lousy mileage, too many martinis were consumed at lunch, meals were high in saturated fat and tasty, the real estate market grew steadily if not spectacularly, and the financial system was pretty stable. The government got this result by limiting the financial products that banks and similar institutions could offer and invest in. Banking was a dull industry with moderate profitability. But recessions tended to be short and recoveries tended to be fast. America was an optimistic nation.

Perhaps the unstated reason for the proposed comprehensive regulation of banker compensation is that the Fed doesn't want to admit error and re-regulate the types of financial products that banks can play around with. In the last 20 years, the Fed has led the charge for the deregulation of banking. It's wanted to allow banks to do anything they want, take any risk they want. No need to recap the result of all that. A simpler way to solve the problem of bank risk levels would be to again limit the products the banks play with. No more CDOs or CDOs squared. No more credit default swaps. No life insurance settlement backed bonds or other financial engineering of doubtful social value. If these products truly have social utility, some not-too-big-to-fail, not federally insured or guaranteed company will come along and offer them. If none does, those products will be revealed to be the sophisticated forms of gambling they appear to be.

Federal regulation of banker compensation is meant to prevent the morally hazardous status quo, where taxpayers cover losses while bankers bank big bonuses. That's a laudable goal but we ought not overly complicate the task of bank regulation.

Speaking of simple points, the Fed holds another periodic meeting next week, where it will decide basically to change nothing. Short term interest rates will be kept at zero and other accommodative measures will be kept in place, with only the gentlest of suggestions that they may ever so gradually be withdrawn but not if the financial services industry lets out even a mere whimper. As a not-so-academic exercise, one might consider what would have been the case if the Fed had, instead of moving interest rates to zero, just lowered them to 2%. A fed funds rate of 2% would have been quite accommodative by historical levels but would have been less conducive to inflation (not a threat at the moment) and to asset bubbles (whoops, please don't look at the stock market, whatever you do). There are a lot of people who hold savings in money market funds and bank accounts, and whose interest income has fallen sharply because of the Fed's indulgences for bankers (i.e., providing a zero percent cost of funds which the banks can turn around and lend at tidy profits). How much income have these unfortunate holders of capital lost? It's hard to say, but we can guestimate.

About $3.5 trillion is held in money market funds. Something like $5.5 trillion is held in bank money market accounts, savings accounts and other interest bearing accounts. That's $9 trillion right there, which multiplied by 2% equals $180 billion per year. Then add federal interest paying investments that effectively have variable rates, like U.S. Treasury bills, TIPS, and U.S. Savings Bonds, which may total in the range of $3 trillion. Multiply this by 2% and you get an additional $60 billion. Then, there are those very unfortunate auction rate securities and perhaps some commercial bonds held by individual investors, and the aggregate income lost from having a zero rate instead of 2% probably totals over a quarter trillion dollars.

A quarter trillion dollars may not seem all that big in America's $14 trillion economy. But ask retailers if they'd like customers to have an extra $250 billion to spend. Granted, not all such interest income, if it were received, would be spent. But even if some of it were saved, those savings would probably have a wealth effect that would make recipients feel a little looser with other income.

Clearly, America's savers cannot look forward to very much interest income for a long time. Thus, the Fed constrains consumer spending even as it tries to foster it with its ultra cheap money that banks don't lend to consumers.

Wednesday, September 16, 2009

In the debate over financial regulatory reform--and especially with respect to the introduction of substantial regulation in the derivatives market--it's important to keep in mind that integrity and honesty have commercial value. You see this in the automobile market, where certain brands are heavily favored due to their quality and reliability. These products pretty much work as expected; unpleasant surprises are uncommon. Consumers pay a premium for these cars. Other makes, with lesser reputations, sell at discounts and often require heavy rebating before they can be moved off dealer lots.

The same could be said for the stock markets. For decades after World War II, the American stock markets were by far the largest and most liquid. Investors ranging from large institutions and multimillionaires to those modestly well-off invested in stocks. This was true even before the advent of the 401(k), which only increased stock market participation across the populace. The U.S. stock markets were also much more heavily regulated than European and Asian stock markets. The high degree of regulation no doubt increased Wall Street's costs of doing business. But it also gave investors confidence that they would get a fair shake. People will plunk down their money if they think they'll be treated fairly.

In the last twenty years, European and Asian nations have strengthened the regulation of their financial markets, adopting structures that often mimic the U.S. regulatory structure. At the same time, the U.S. has allowed its financial markets to deregulate to a large degree, with much of the banking system sliding into the unregulated derivatives market. The quality of the work of American regulators has also slipped, with the Federal Reserve and other bank regulators missing the boat on the mortgage mess and the SEC failing to catch Bernie Madoff. The result has been a financial crisis and the Great Recession, which unfortunately began in the U.S. financial markets. Many Americans have pulled back from the stock markets. In spite of the recent bull market, a lot of long term investors remain on the sidelines and the market surge is driven by day traders, momentum traders and other diverse and sundry forms of short termers. It seems that owners of capital really dislike being misled and cheated; they're funny that way.

Wall Street and large European banks are fighting the regulation of derivatives. However, financial markets need investor money to function--we won't have a healthy financial system if banks simply trade with each other. And investors, so recently burned, would like an environment where government watch dogs pace restlessly.

There has been a lot of debate and pushback in Europe about regulating derivatives there. It's unclear how the European regulators will proceed, and they may tread more lightly than the Obama administration. This should be viewed as an opportunity. If the American derivatives markets acquire a reputation for fairness and integrity, they will attract investor funds. Let Europe operate derivatives casinos. Many more people put money into federally insured deposit accounts than on red or black in Las Vegas.

Sunday, September 13, 2009

One consequence of the regulatory reforms that the Obama administration has proposed will be a smaller derivatives market than existed in the boom years before 2007. We have learned that the derivatives market is inextricably intertwined with the banking system. We've also learned that, instead of ameliorating risk, derivatives exacerbate risk and then concentrate it on a few firms or even one large financial institution (read AIG). After all that, Wall Street firms are still making plans to buy life insurance contracts and package them into asset backed securities. Risk wouldn't be spread out and softened. Instead, investors in the new contracts would simply be gambling on longevity, nothing more or less. Insurance companies and other financial companies wouldn't have their risks reduced; if anything, insurers' risks would grow as policies that historically would have been cancelled by customers no longer needing coverage are bought up and kept in force by investors in the new insurance-backed securities.

The proposals directly addressing derivatives call for the public trading and centralized settlement of standardized derivatives contracts, and increased recordkeeping and reporting for customized derivatives. These measures will help. But they are only some of the steps in the journey.

The final steps in reshaping the derivatives market will come from bank regulatory reform. This is because virtually all the risks in the derivatives market eventually connect back into the banking system one way or another. That's what we've learned with CDOs, CDOs squared and, especially, credit default swaps. The only parties that can play in the derivatives sandbox are the big banks and their counterparties. The big banks will almost always be connected somehow to standardized derivatives contracts (after all, they will capitalize the central clearing agency, and if it faces insolvency, they will have to ride to the rescue because they can't afford to let it go under). And the big banks are the only credible counterparties for customized derivatives. Investors wouldn't buy a customized derivative from anyone else, because anyone else wouldn't be too big to fail and might be unable to honor its obligations under the derivative contract.

Bank regulatory reform includes a couple of measures crucial to the future of the derivatives market. First, bank leverage ratios will be lower. Leverage was a key element to the explosion of the derivatives market in the early 2000s. So a contraction of leverage necessarily means a smaller derivatives market. Second, bank capital requirements will be strengthened and regulators will look askance at special purpose vehicles and other accounting slights of hand that purported, but failed, to shift the risk of loss from derivatives away from the banks. Thus, derivatives exposure will require banks to maintain higher levels of capital without having a convenient potted plant to dump them into. This will raise the cost of doing business in the derivatives market and act to limit the quantity of derivatives outstanding.

Thus, even though no federal regulator will attempt to dictate the quantity of derivatives contracts created or traded, the effect of federal regulatory reform will be to prevent them from reaching the gargantuan levels of yesteryear. This isn't bad. While proponents of derivatives argue that they promote growth, experience tells us that they also heighten the risk of financial crises, which have a notably negative effect on growth. A smaller, kinder, gentler derivatives market could help foster growth, but hopefully at a more sustainable level. We shouldn't fixate on what will produce growth next quarter or even next year. A long term perspective is needed now.

Wednesday, September 9, 2009

Banking today is structurally different from, say, three years ago. There are no more large brokerage firms under SEC regulation. All the major financial institutions are banks regulated by the federal banking authorities. There are notably fewer big financial institutions. Many faces in executive suites have changed.

But operationally, it would seem that plus ca change, plus c'est la meme chose. The banks still make big profits and pay big employee bonuses. They also take big risks. Today's Wall Street Journal reported on p. A1 that "value at risk," a measure of the potential for trading losses, is for the largest banks greater than it was in 2008, 2007 and even the boom year of 2006. In other words, after all the Federal Reserve accommodations, federal bailouts, bonus controversies, Congressional hearings and bank failures, business as usual continues and the banks are, if anything, putting taxpayers at greater risk than ever before.

That's bad, since business as usual is how we got into the recent credit crunch and Great Recession. Why haven't things changed? A couple of likely explanations suggest themselves. First, bank regulatory reform hasn't happened, and seems to be slipping toward the back burner. Health insurance reform is an extremely important priority, and, after eight years of meandering, the war in Afghanistan needs definitive direction. But let's remember that the current Great Recession was brought on by risky banking practices and more than anything the electorate chose Barack Obama as President to straighten out the economic mess. His administration cannot afford to lose focus of the need for financial regulatory reform. In the absence of reform, what else can we expect other than bad old business as usual?

The second likely explanation for the return and elevation of the banking system's risks is that the Fed, once again, is pumping out cheap credit. This time, it's really cheap credit, virtually free. Recall how banks make money. They borrow it (from depositors, commercial lenders, and nowadays most prominently the Federal Reserve) and lend it out or invest it. When the cost of borrowing is low, comparatively high risks seem sensible. (This is why so many people paid ridiculously high prices for houses when they could get 100% financing with interest only or option ARM loans--the credit was incredibly cheap so what did the price of the house matter?) High cost of funds imposes risk management discipline. Cheap money encourages profligacy.

How many times in the last decade or so have we seen this from the Fed? We've had the tech stock bubble, the housing bubble, the credit bubble, the 2008 petroleum bubble and now today's stock market, gold and who knows what else bubble. The Fed has made clear that it's going to keep credit cheap for an extended period of time. So why wouldn't the big banks ratchet up risk? Their costs are under control, courtesy of the Fed. And they know the taxpayers guarantee all their liabilities 100 cents on the dollar. What's not to like about risk? It's a great way to boost employee bonuses, when all goes well.

But the new data about banks taking more risk than ever raises the specter of another big asset bubble. If we are working our way toward another bubble, we'd better hope that this one defies the laws of economics and never pops. Since the Fed is already maintaining a zero interest rate for banks that borrow from it, it can't pull the nation out of another economic bust by lowering interest rates. There's no such thing as negative interest, because bank depositors will simply withdraw their funds and put the stuff in mattresses (which would mean the collapse of the financial system). The current combination of no bank regulatory reform, the cheapest credit possible from the Fed for an extended time, and a resumption and expansion of business as usual among the big banks could be deadly. With nothing changing, what can we expect except apres cette fois, le deluge?

Sunday, September 6, 2009

The latest product from Wall Street's financial engineers evidently will involve buying life insurance policies from the elderly and infirm, pooling the purchased policies, paying the premiums and collecting on the policies when the original owners die. Investors in these life insurance pools bet that the proceeds from policy payouts will exceed the cost of purchasing the policies and paying the premiums (plus bankers' commissions, underwriting fees and other expenses). They receive better returns if the original owners die sooner than expected. Longevity, on the other hand, hurts the profitability of the investment. The original owners, who might be running out of other savings, sell the policies to get a lump sum, which they use to live on and pay medical and other expenses.

Let's take a look at the new, post-mostgage crisis Wall Street. The scene opens in the lobby of a too-big-to-fail bank that deals in life insurance backed securities.

"Please, sir, could I have some more?"

"I'm sorry, Harry, but all I can offer you is $40,000."

"But, Mr. Big Banker, you gave me $50,000 for my first life insurance policy and it had the same amount of coverage," said Harry.

"Interest rates have ticked up. In order to make the deal numbers work, I have to lower the amount I offer you," said the banker.

"I've lost my job and defaulted on my mortgage and my credit cards. My kids are starving and my wife is about to leave me. Couldn't you give me just a little more?"

"Harry, business is business. The offer is $40,000 firm."

Harry clutched his chest and began to choke. He fell on the floor and thrashed around.

"I can't breath," he gasped. Then he lost consciousness.

A man rushed up and began administering CPR.

"What are you doing?" demanded the banker.

"I'm a doctor. I'm trying to help this man."

"I remember you, Doctor," said the banker. "I placed a life insurance backed security in your retirement account, one that includes an interest in this man's first life insurance policy. If you save his life, the investment will be worth less."

"I'm a physician. I'm bound by the Hippocratic Oath to help this man," said the doctor. "Now please step back to give me more room to work."

Another man ran up, took Harry's hand in a comforting way and began whispering.

"What are you doing?" demanded the banker.

"I'm a member of the clergy. I'm praying for this man."

"I know who you are," said the banker. "I sold a life insurance backed security to your church's endowment fund. It includes an interest in this man's first life insurance policy. If you help save that man, your endowment fund may end up with a smaller return."

The clergyman gave the banker a cold look and said, "Let me just say that I will pray for you as well as poor Harry, because you need it."

Exasperated, the banker stormed out of the bank, shouting, "You people couldn't make a dollar to save your lives."

He went over to the assisted living facility across town, where he stopped in on his latest prospect, 75-year old Wilbur.

"Let me go over it again. You sell me your life insurance policy for $200,000. That will give you more money to cover the costs of staying here, maybe as long as three more years. Since you won't be spending the entire $200,000 at once, you invest the unused portion in one of my life insurance backed securities, and it will earn a good return until you need the money."

"Wait a minute," said Wilbur. "You want to buy my policy and then sell it back to me?"

"It's possible the security you invest in could contain the policy we buy from you, yes."

"Then you're asking me to invest in my own death."

"Wilbur, it's a win-win situation for you. You get the money to cover future expenses, so you win that way. But if you die early, your estate enjoys increased value from the security. You can't lose."

"Why do I smell a rat all of a sudden? You should talk to Herbie next door. He's almost broke, and they're going to kick him out next week."

"Why don't you investment bankers do something constructive, like finance a new car company in America?"

"The bonuses are higher in the asset backed securities business."

"I ought to throw you out of here."

"Please wait until you sell us your policy. Then do something more physically taxing than your system can stand."

With the strength of righteous anger, Wilbur rose up from his wheelchair and tossed the banker out of his room. Then he smiled broadly, feeling better than he had in months.

The banker was leaving the assisted living facility when he was stopped by one of the attending physicians.

"So, will you finance the new product I'm developing to combat hospital-borne infection?" asked the physician.

"You told me that the product would save the lives of many patients," said the banker.

"That's what the clinical results show."

"I can't finance that product. It would undercut the interests of my life insurance backed securities investors. I have fiduciary duties to them, and must do my utmost to ensure that they maximize their profits."

"But we're talking about reducing human suffering," said the physician.

"You're talking about reducing human suffering," said the banker. "I'm talking about reviving the vitality of America's capital markets."

"Can't America's capital markets finance something besides gambling on the longevity of sick people?" asked the physician. "How about something productive that would help people, resuscitate the economy and increase employment?"

"There aren't many good investments you can make today in real businesses. Most real businesses are in poor shape. The Fed has pumped a lot of cash into the financial system and that cash is looking for a place to be invested. I'm developing the product that will attract that cash. The underwriting margins for life insurance backed securities look very attractive, and that would mean good-ole-days-size bonuses. You can do good, if you like, doctor. I intend to do well."

Thursday, September 3, 2009

In recent days, the financial markets seem to have gone gaga. Gold is approaching $1,000 an ounce again. Bank and other financial stocks have rallied. The two trends are analytically inconsistent. Gold is favored when the economy is falling apart, inflation is surging or the political situation is deteriorating. In other words, it's an investment of last resort. Bank and other financial stocks make the most sense when economic trends look rosy. Since banks and other financial institutions lend to or invest in large segments of the economy, it is logical that they would rise when the picture looks good.

When both gold and financial stocks rise, cognitive dissonance sets in. But only if you assume markets are rational and interrelate with each other. While there may be a vague and general relationship between gold and financial stocks, for the most part, they are separate venues where different opinions are expressed through trading activity.

Markets require differences of opinion to function. Someone has to prefer cash to a stock, bond, gold or what have you, in order to sell. Someone else must prefer to own the stock, bond, gold, etc. instead of cash, in order to buy. These differences of opinion are the foundation for the supply and demand that interact in markets.

But different markets don't necessarily reflect the thinking of the same people. People who think inflation is around the corner and the economy is headed for a double-dip recession are snapping up gold. But they're very likely not selling or shorting financial stocks. People who see green shoots at every turn are speculating in financial stocks. But they're probably not selling gold or shorting gold stocks. Just as there is no unified field theory in physics, there is no unified financial market. Instead, gloomier investors express their opinions in one market. Optimistic (or opportunistic) investors express their views in a different market.

If you're trying to figure out what's going on, don't look for overarching explanations of all market activity. The last three times gold approached the $1,000 an ounce range (March and May of 2008 and February 2009), financial stocks were wobbly. Now, almost irrationally, they are not. What really seems to be going on is that in the low volume trading of the pre-Labor Day vacation period, different investor opinions are being expressed in different markets. These views can't easily be reconciled. Perhaps the most they indicate is the likelihood of greater volatility in the near term future.

Disagreements are a natural part of market activity. Avoid reading a lot of significance in recent gold and financial stock price movements. Gold reached the $1,000 range three times in the last 18 months, yet mobs don't rage in the streets and the Constitution remains the law of the land. The revival of financial stocks doesn't necessarily mean that all will be well. The financial markets are heavily populated with soothsayers and diviners that attribute talismanic significance to price movements of particular investments. There is no all-knowing indicator in the markets. There's simply the usual cacophonous potpourri of humanity.

Tuesday, September 1, 2009

Today's 185 point drop in the Dow Jones Industrial Average is attributed by many in the financial press to the market being "overbought" or "ahead of itself." More specifically, price-earnings ratios for the S&P 500 are above 18, whereas the historical average is around 16. At the recent market low in March 2009, the p/e ratio was around 11. Maybe a sell-off makes sense. However, there is nothing inevitable about a drop from a p/e ratio of 18. In the late 1990s, the S&P 500 had a p/e ratio in the high 20s, yet the index proceeded to go higher. Why, then, would the market drop from a p/e ratio of 18? Because the future is uncertain. (Actually, it was uncertain in the 1990s but people deluded themselves into thinking it wasn't.)

The federal government has relied heavily on the financial equivalent of methadone to get the economy through the past year. The Fed printed money nonstop, while the Bush and Obama administrations greatly increased deficit spending. These measures treated the symptoms of the problems, and soothed some of the pain. But they didn't get at underlying causes. Doctors don't treat cancer by administering painkillers. They employ surgery, chemotherapy, radiation therapy and other measures aimed at removing or suppressing the disease. But federal policy has been ineffectual at dealing with underlying problems.

This recession began as a crisis of the financial system, not the real economy. The financial system made a vast quantity of really dumb mortgage loans, and extremely well compensated Wall Street executives managing the big banks somehow couldn't figure out that this gargantuan mass of future losses was looming. Perhaps they were too busy counting their enhanced compensation. We're now familiar with the mess that followed. Real estate, previously thought by Wall Street not to be subject to ordinary market forces such as downward price movements, fell in value. The vast ocean of bad mortgage loans then did what bad loans do--they defaulted and created losses. A lot of losses, since there were really a lot of bad loans. The flow of losses persists, since rising unemployment leads to more defaults and foreclosures. At this point, many of defaults are of seemingly good, prime mortgages owed by people who lost their jobs. With unemployment expected to rise, mortgage losses will be hitting the banking system for years.

There probably are trillions of dollars of unrecognized losses in the banking system, especially when one considers the foreclosures to come. Banks continue to cut back on lending in order to preserve their capital to cover more mortgage and other recession-related losses. There won't be a lively flow of bank credit to revive the economy any time soon.

The Federal Reserve printed trillions of dollars to keep the banking system propped up, and has managed to prevent Armageddon. But that approach does little to ameliorate the trillions of dollars of unrecognized losses that haunt the banks. The Fed's approach simply transferred most of the losses to the future. Federal bailout measures, like TARP, transferred a lot of losses to taxpayers. The largely ineffectual mortgage modification programs tend to transfer losses to taxpayers as well. (Banks and investors in mortgage-backed securities are taking some losses, but the total number of mortgage modifications is so low that the result is like a tiny drop in a 55-gallon barrel.)

It seems to be the federal government's strategy--a strategy that is little more than hope--to keep the financial system on life support long enough that the real estate market revives and rising real estate values erase the unbooked losses. But with mortgage credit scarce and consumers now embracing newly found prudence, real estate prices will probably not return to 2006 levels for a decade. Meanwhile, the banking system will remain crippled by its vast pool of unbooked losses. Credit will continue to be tight. Economic growth will be slow.

Hope won't win the day. The PPIF program, a public-private sector concept that would supposedly buy up toxic assets from banks, isn't very active, because banks are allowed by a recent politically coerced relaxation of accounting rules to sweep dodgy assets under the carpet instead of recognizing their losses. If they sell those assets to PPIF, they would have to book losses. That would detrimentally impact executive bonuses, something to be avoided at all costs.

The federal government's focus should shift from loss transference to spurring economic growth. Targeted stimulus spending, focused tax breaks, public works spending (especially for needed infrastructure repairs and improvements), and other growth-oriented measures are in order. Measures to maintain retiree buying power could enhance consumer confidence. Social Security retirees are not likely to get a cost of living increase this coming January because of the absence of inflation. But their medical insurance expenses will rise, so their real incomes will shrink. If you want to see people pull back on spending, reduce their incomes. A consumer-driven economy such as America's cannot recover in an environment where incomes are shrinking. When Wall Street bankers are collecting multi-million dollar bonuses because the federal government saved their employers, it's really weird to get wound up about "windfalls" like a 1% increase for Social Security recipients, whose average benefit is slightly over $11,000 a year.

A growing economy can more easily absorb the impact of the unbooked losses remaining in the financial system. A stagnant economy will only be made more stagnant when the losses have to be recognized. The government should concentrate on stimulating the real economy.

The future direction of the stock market is likely to depend on earnings growth--real earnings growth, not the contrived stuff that we've recently seen. With ultra-cheap federal credit and the politically coerced relaxation of accounting standards, the banking system has pushed a lot of losses into the future and returned to "profitability." But a strategy of loss transference has a limited half-life; the losses have to booked sooner or later and the impact on the economy is likely to be ugly. The stock market can't continue to thrive on "earnings" resulting from federal loss transference policies. The market--and the economy--need real earnings if the future is to be bright.

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